Fitch Affirms Downer at 'BBB'; Outlook Stable

(The following statement was released by the rating agency) Fitch Ratings-Sydney-09 September 2020: Fitch Ratings has affirmed Downer EDI Limited's Long-Term Issuer Default Rating and senior unsecured rating at 'BBB'. The Outlook is Stable. The affirmation also applies to all senior unsecured debt issued or guaranteed by Downer, including debt issued by its subsidiary, Downer Group Finance Pty Limited. The affirmation reflects Downer's strong work-in-hand (WIH) of AUD42.2 billion as of the financial year ended June 2020 (FY20), which was supported by the Australia-based company's continued shift towards recurring maintenance-style contracts, compared to historically more volatile construction- and mining-type revenue. Downer's core urban services businesses have proven resilient, despite the impacts of the coronavirus pandemic on the company and the broader Australian economy. However, losses on major construction projects, and reduced cash conversion in the year resulted in Downer's funds from operations (FFO) net leverage increasing to 3.2x (FY19: 1.5x), above the level where we would consider negative rating action. However, we expect leverage to decline in FY21, to a level consistent with Downer's rating as cash conversion returns towards historical levels. The company's AUD400 million equity raise completed post year-end, will be used to acquire the Spotless minorities, but it will also go towards debt reduction. Key Rating Drivers Resilient Urban Services Business: Downer is Australia's largest diversified-services group that offers end-to-end capabilities in Australia and New Zealand. Downer has continued to progress its transformation away from cyclical mining and engineering and construction towards long-term stable urban services-based revenue, mainly in the infrastructure and civil sectors. Segments, excluding mining, made up 88% of total group revenue in FY20, up from 74% in FY14. Downer's core urban services businesses proved resilient over FY20, achieving around 97% of FY19's EBITA in FY20, despite the pandemic-related impacts, and Fitch expects improvements within these businesses from FY21 as Australia and New Zealand reopen from lockdowns used to curb the spread of the virus. Portfolio Restructuring, Impairment charges: Downer recognised AUD386 million in one-offs and restructuring charges in FY20, including an AUD165 million impairment to the value of Spotless's goodwill, reflecting the ongoing impact of COVID-19 on its hospitality division, a reduction in earnings from its infrastructure and construction division and lower terminal growth rates. An additional AUD142 million of restructuring and exit costs were also recognised for the winding down of its engineering and construction businesses, as Downer looks to exit from inherently riskier construction type-revenue, as well as the exit costs for its mining and laundry divisions, which remain under review for an exit or sale. We believe, once completed, the shift towards Downer's core urban services businesses will lower revenue volatility and result in a more sustainable earnings model. Cash Conversion to Improve: Downer's cash conversion has been above 80% since FY11 (FY20:39.5%), however FY20 conversion was affected by COVID-19, losses in its construction division and working capital movements on major projects. Operating cash conversion improved in the second half of the financial year to 74%, and Fitch expects cash flow to continue to normalise over FY21. Lower cash conversion resulted in Downer's leverage exceeding our negative sensitivity of 2.5x FFO net leverage in FY20; however, we expect leverage to decline to 2.3x in FY21 and lower thereafter. Equity Raising; Spotless Acquisition: Downer successfully completed a AUD400 million equity raising in 1HFY21. Proceeds will be used in the buyout of minorities at the Spotless level for AUD135 million, which will give Downer 100% ownership of Spotless, and for restructuring costs and debt reduction. Downer's FY20 FFO net leverage was 2.7x on a pro forma basis, accounting for the equity raising and minority buyout. Downer has guided full Spotless ownership will provide cost savings of around AUD10 million-15 million a year through consolidation of the group's debt platform and elimination of redundant corporate structures. The expected refinancing of the Spotless debt at the group level will also remove the structural subordination present for Downer's creditors, as cash generated at Spotless has been first applied to debt outstanding at that entity. Focus on Government Spending: Government-related revenue has continued to increase as a proportion of total revenue, as the Australian economy shifts away from the resources sector and the government prioritises infrastructure spending. Fitch continues to expect government spending to be the primary source of major new opportunities for Downer group over the medium term. Mining, Laundry Exit: Downer has flagged that its mining business, which contributed 16.4% or AUD79 million, of underlying EBITA, is under review, with a view towards a potential sale, while the laundry business is also up for disposal. Fitch has not included any disposal proceeds from these segments in its base case, but expects that it would be neutral to the rating. The divestment should have a minimal impact on FFO, however any disposal could provide Downer with rating headroom, to the extent that cash proceeds are used to reduce leverage rather than to improve shareholder returns. A disposal would further shift Downer towards less capital-intensive service-based revenue, with these divisions contributing over half of Downer's annual capex, while further lowering earnings volatility and improving the overall business profile. Derivation Summary Fitch rates Downer applying the business services navigator framework. Downer's scale and diversification across sectors has improved following its Spotless acquisition. However, the company's international diversification remains limited with revenue largely generated in Australia and New Zealand. This limits its rating to the 'BBB' category. The company's lack of international diversification and smaller scale is reflected in the two-notch difference to Compass Group (LON:CPG) PLC (A-/Stable), despite similar financial profiles. No Country Ceiling, parent-subsidiary or operating environment aspects affect the rating. Key Assumptions - Revenue growth of 1% in FY21, increasing to 3.0% from FY23 - EBITDA margin, adjusted for lease expenses, of 5.3% in FY21, increasing to 5.9% by FY24 - AUD145 million of non-recurring cash expenses in FY21 related to restructuring, legal expenses and portfolio exits - Capex of around 3.0% of revenue a year - Dividend payout ratio between 50% and 60% of consolidated underlying net profit after tax before acquired intangible amortisation - No disposal of mining or laundry segments RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: - No positive rating action is anticipated over the medium term due to Downer's geographic concentration and scale Factors that could, individually or collectively, lead to negative rating action/downgrade: - FFO net leverage rising to above 2.5x for a sustained period (FY20: 3.2x) - EBITDA margin (adjusted for leases) falling below 5.0% for a sustained period (FY20: 4.7%) Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure Strong Liquidity: Downer had AUD588.5 million of cash alongside AUD1,270 million of undrawn committed facilities at end-June 2020 and a weighted-average debt duration of 3.4 years (FY19: 3.6 years). Downer has demonstrated access to a wide range of funding sources, including syndicated loans, local and international capital-market debt and equity. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations Fitch has assessed Downer's exposure to ESG outside of the standard business service defaults, due to the group's exposure to a more diverse range of end businesses compared with business service peers. The highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg. Downer EDI Limited; Long Term Issuer Default Rating; Affirmed; BBB; RO:Sta ----senior unsecured; Long Term Rating; Affirmed; BBB Downer Group Finance Pty Limited ----senior unsecured; Long Term Rating; Affirmed; BBB Contacts: Primary Rating Analyst James Hollamby, Associate Director +61 2 8256 0347 Fitch Australia Pty Ltd Suite 15.01, Level 15 135 King Street Sydney 2000 Secondary Rating Analyst Kelly Amato, CFA Director +61 2 8256 0348 Committee Chairperson Vicky Melbourne, Senior Director +61 2 8256 0325 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Criteria Corporate Hybrids Treatment and Notching Criteria (pub. 11 Nov 2019) (https://www.fitchratings.com/site/re/10100477) Corporate Rating Criteria (pub. 01 May 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10120170) Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10090792) Country-Specific Treatment of Recovery Ratings Rating Criteria (pub. 27 Feb 2020) (https://www.fitchratings.com/site/re/10111386) Applicable Model Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s). 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